Wednesday, 11 July 2012

Crisis, what crisis? Arrogance and self-satisfaction among macroeconomists

My
recent post
on economics teaching has clearly upset a number of bloggers. There I argued
that the recent crisis has not led to a fundamental rethink of macroeconomics.
Mainstream macroeconomics has not decided that the Great Recession implies that
some chunk of what we used to teach is clearly wrong and should be jettisoned
as a result.To
some that seemsself-satisfied,
arrogant and profoundly wrong. I’ve already mentioned one example,
but here
is David Ruccio, who asks in contradiction “What I want to know is, which part
of that theory doesn’t need to be reexamined in light of the events of the past
few years?”

He then
gives some examples. The first is a bit annoying. He says “where is the history
of the theories and debates that have taken place in macroeconomics since at
least the publication of John Maynard Keynes’s General Theory?”
It’s annoying because I ended my post making exactly this point, and arguing
that some account of this history of macroeconomic thought should be brought
into the teaching of the macroeconomics core. But the issue I want to focus on
here is why I don’t think the financial crisis requires a fundamental rethink
of macroeconomics, despite articles in the media (e.g. here)
suggesting is should.

Let me be
absolutely clear that I am not saying that macroeconomics has nothing to learn
from the financial crisis. What I am suggesting is that when those lessons have
been learnt, the basics of the macroeconomics we teach will still be there. For
example, it may be that we need to endogenise the difference between the
interest rate set by monetary policy and the interest rate actually paid by
firms and consumers, relating it to asset prices that move with the cycle. But
if that is the case, this will build on our current theories of the business
cycle. Concepts like aggregate demand, and within the mainstream, the natural
rate, will not disappear. We clearly need to take default risk more seriously,
and this may lead to more use of models with multiple equilibria (as suggested by
Chatelain and Ralf, for example). However, this must surely use the
intertemporal optimising framework that is the heart of modern macro.

Why do
I want to say this? Because what we already have in macro remains important,
valid and useful. What I see happening today is a struggle between those who
want to use what we have, and those that want to deny its applicability to the
current crisis. What we already have was used (imperfectly, of course) when the
financial crisis hit, and analysis clearly suggests
this helped mitigate the recession. Since 2010 these positive responses have
been reversed, with policymakers around the world using ideas that contradict basic
macro theory, like expansionary austerity. In addition, monetary policy makers
appear to be misunderstanding
ideas that are part of that theory, like credibility. In this context, saying
that macro is all wrong and we need to start again is not helpful.

I also
think there is a danger in the idea that the financial crisis might have been
avoided if only we had better technical tools at our disposal. (I should add
that this is not a mistake most heterodox economists would make.) A couple of
years ago I was at a small workshop organised by the Bank of England and ESRC,
that got together mostly scientists rather than economists to look at
alternative techniques of modelling, such as networks. One question is whether
finance and macro could learn anything from these other disciplines. I’m sure
the answer is yes, and I found the event fascinating, but I made the following
observation at the end. The financial crisis itself is not a deeply mysterious
event. Look now at the data on leverage that we had at the time, but too few
people looked at before the crisis, and the immediate reaction has to be that
this cannot go on. So the interesting question for me is how those that did
look at this data managed to convince themselves that, to use the title from Reinhart
and Rogoff’s book,
this time was different.

One
answer was that they were convinced by economic theory that turned out to be
wrong. But it was not traditional macro theory – it was theories from financial
economics. And I’m sure many financial economists would argue that those
theories were misapplied. Like confusing new techniques for handling
idiosyncratic risk with the problem of systemic risk, for example. Believing
that evidence of arbitrage also meant that fundamentals were correctly
perceived. In retrospect, we can see why those ideas were wrong using the
economics toolkit we already have. So why was that not recognised at the time?
I think the key to answering this does not lie in any exciting new technique
from physics or elsewhere, but in political science.

To understand why regulators and
others missed the crisis, I think we need to recognise the political
environment at the time, which includes the influence of the financial sector
itself. And I fear that the academic sector was not exactly innocent
in this either. A simplistic take on economic theory (mostly micro theory rather
than macro) became an excuse for rent seeking. The really big question of the
day is not what is wrong with macro, but why has the financial sector grown so
rapidly over the last decade or so. Did innovation and deregulation in that sector add to social
welfare, or make it easier for that sector to extract surplus from the rest of
the economy? And why are there so few economists trying to answer that
question?

Postscript. As Richard Portes points out to me, the last sentence is a little unfair: see here and here, for example

27 comments:

Multiple equilibrium models tend to strike me as strained, because of the need to explain how the system falls below the intervening unstable equilibrium to converge on the lower stable one, and they also have the problem of explaining how to devise policies which would take the economy back from an un-shifted lower stable equilibrium, to a point above an un-shifted intermediate unstable equilibrium, so that it can converge on the upper stable equilibrium (and the dynamics of the model have to be able to accommodate both the fall and the policy-driven recovery). I tend to prefer single equilibrium models where some shocks simply disturb the system without shifting the equilibrium and others, in a sense more Keynesian shocks, shift the equilibrium down. (So I'm defining a Keynesian equilibrium as one in which unemployment is permanently, and not just temporarily, elevated beyond the full employment level.) That said, I admit that it would be difficult to distinguish the two cases empirically, and a shock which might shift my single stable equilibrium down might equally knock the system down below an unstable equilibrium in a multiple equilibrium model.Arguably the biggest weakness in textbook macro models has been a tendency not to give enough attention to how the banking and finance sectors behave, which would imply that we need to add optimizing behaviour in that sector into the macro models. To add some Hawtrey into the Keynes.

It doesn't always require a measurable shock to shift the economy from one equilibrium to another. I have in mind the models of "sunspot equilibria" (see here http://www.karlshell.com/sum1.html) in which the economy can shift between equilibria arbitrarily--essentially, which equilibrium we observe depends only on which one people believe we are at, so anything that shifts those believes will produce a shift from one equilibrium to another.

Generally speaking, you can still derive policy prescriptions from multiple-equilibria models--while it may not be possible quantitatively to see what policies will move us from one equilibrium to another, it is quite possible to implement policies that will locally shift the equilibrium and can therefore be welfare improving.

In statistical physics multiple equilibrium models are natural models of some real systems. Single equilibrium models are natural models of simpler real systems. (Ising models come in both flavors. Recently, multiple equilibrium models have been getting much attention. They are similar to some models of social systems.) In multiple equilibrium models, several equilibria may be lowest. Several equilibria may be stable without being lowest. The picture is more complicated but it is realistic.

If you want to know how a system can move from one equilibrium to another, one answer is random motion. In real life, there is always random motion (at least, it appears random to us), so no equilibrium is perfectly stable.

In complex systems, moreover, equilibrium can be more fiction than fact, in that a real system never gets close to equilibrium. A closed system can be expected to approach equilibrium (in the long run) but economic systems are open systems, subject to external shocks (such as political and technological shocks), and therefore equilibrium can easily turn out to be an irrelevant mathematical concept. I don't mean to dismiss equilibrium as meaningless but I do think there's a fundamental weakness in not considering why it may be inappropriate in real circumstances.

I came across this provocative comment at the first piece in June by Olafur Margeirsson. I have never heard this before.

"I must ask you, are you speaking of the IS-LM model? For there is nothing truly Keynesian in it. Hicks already had it in mind at least 5 years before Keynes wrote the GT and Keynes in fact rejected his analysis in a private letter to Hicks. The IS-LM is not Keynesian but "fiscal-neoclasscial".

These guys are opportunists from other parts of the 'social sciences'.

There's approximately a fixed amount of resources available for all social sciences. This may take the form of direct subsidy, or it may take the form of demand by students for undergrad/grad programmes etc.

It's perfectly rational for all the old Heterodox axe-grinders and other quantitative-method haters etc to make the best of the financial crisis by extrapolating to a crisis in academic economics. Obviously the connection is seamless.

"The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?"

The basic problem with macro and micro highlighted by the crisis is that too many economists who have influence on policymaking believe that both macro and micro economic systems are "self-correcting and self-stabilising" by nature. (Or even if they don't "believe it" religiously, are happy to use it as an assumption almost unthinkingly.) There's also a distressing tendency to appeal to "state of nature" arguments as a moral value scheme.

This is the root cause of the deregulation of the financial sector. Said deregulation allowed it to grow, largely in ways that merely involved using technology to amplify the recreation of commercial strategies that existed before 1929 and were then regulated.

A parallel belief is also virulent amongst economists - market relativism - basically if something is the product of a market, they cannot assess it to be low value. And that answers why few are interested in investigating.

A great example of this is the high-frequency trading arms race. There's plenty of circumstantial evidence that HFT favours big firms in an oligopolistic manner, that some firms abuse their power in ways similar to insider trading. Further, there's solid modelling evidence (see Beinhocker's book) to suggest that extreme liquidity (the usual cited benefit) actually creates increasing volatility in a dangerous positive feedback loop.

Yet ask almost anyone in financial economics they'll default to defending HFT as a "natural" outgrowth of the market and often in addition cite liquidity to defend millisecond and shorter trading. And ask anyone in macro or micro about it and they'll tend to defer to the financial economists...

I think, very simply, there's something important being missed: while it can be argued that "somehow" regulation was suddenly loosened, and innovation and speculation intensified in response, as a "natural" result, this is seeing things upside down.

The very pressure to go into increasingly speculative and financial-innovative/HFT mode comes, first, from the evaporation of the sphere where more traditional productive investment can take place. Even in the Chinese economy, investment is occurring, not in places where it does the greatest good for the greatest number, but in places where maximization of profit is the driver.

As long as you have an overall economic system that is structured by the goal of maximizing ROI with return being financial, rather than social, in definition, this kind of traditional crisis of overproduction - signaled by a massive and intensive wave of speculative adventuring - is going to occur over and over again.

Nothing less than a complete transformation of the principles of investment and production is going to change that fact.

Good points. The one error in Metatone's comment above is that it attributes the "root cause" of deregulation to modeling instead of politics.

Your comment rightly emphasises the importance of making political decisions. I'm not so sure "the sphere where more traditional productive investment can take place" did evaporate; more likely, the returns in speculative finance were easier and larger due to the huge flow of money at high velocities (epitomized by high-frequency trading, but not limited to that).

'To understand why regulators and others missed the crisis, I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself. And I fear that the academic sector was not exactly innocent in this either. A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking. The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?'

The answer is in this very paragraph. In what way does it make sense to argue that 'macro economics' can be quarantined from the failure of 'the theories from financial economics'? Is it really possible to claim that there was no interchange between the two, no dialogue? Of course not. This simply makes financial economics the scapegoat for wider failings.

These issues are sociological and political, including the sociology of the segment of knowledge branded as economics. If, as is claimed,'there so few economists trying to answer that question' the answer lies in the effects of the sort of regulatory capture of the political system by financial institutions described by Simon Johnson and the role played by some notable economists on behalf of those financial institutions, all of which acts against precisely the sort of forensic intellectual effort that is required.

The sad thing is that none of us can move on until economists move away from spurious notions of objectivity and instead reflect on the conditions, political, social and, yes, economic, under which they produce knowledge for consumption by financial institutions and political elites. It is economics itself that is in need of being endogenised.

Don't you think that artificiality of economics as a discipline is the root of the problem? Ultimately, the phenomenon we are looking at is 'political economy', the generation and allocation of resources. The 'market' is far from transparent and level - in many domains it is a political construct, political being broadly interpreted (Barclays and LIBOR.

To my mind it is bizarre to claim any credibility for economics when there is no accepted theory addressing the role of banking, finance, credit and money. How is it possible that 150 years after Bagehot, we still don't really know how money and credit operate (MMT vs MMR vs monetarism etc)? The disputes over economic theory and policy (Krugman vs Austerians etc) are patently ideological. What we really need is a modern-day Jonathan Swift to expose professional economics for the farce that it is.

Have you read Godley and Lavoie, Monetary Economics (2007) yet? Or Godley and Cripps, Macroeconomics (1983)? It's not like this is new stuff. The late Wynne Godley, formerly of the UK Treasury and Cambridge Univ, predicted what would happen to the EMU at its inception, and he also correctly predicted the financial crisis. Jan Hatzius, chief economist at Goldman, uses Godley stock-flow consistent macro modeling based on the sectoral balances.

"In retrospect, we can see why those ideas were wrong using the economics toolkit we already have. So why was that not recognised at the time? I think the key to answering this does not lie in any exciting new technique from physics or elsewhere, but in political science.To understand why regulators and others missed the crisis, I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself."

The book by John Kenneth Galbraith 'The Great Crash 1929', gives us the answers I believe. When he talks about a 'speculative orgy' and the belief that everyone was going to be rich (this time through house prices), is something that was repeated in the 2000's

The problem is that the use of a microeconomic optimising framework that you insist ,,,, on limits the scientific value of the models. There is first the whole question of how reasonable it is to model the behaviour of a single representative household as standing for a whole society of millions of individuals. It shifts the emphasis away from the aggregate behaviour of the whole economy that we are interested in understanding. Instead of focussing on the problem of effective demand in terms of the transactions between income constrained individuals, it nets out all that is important.

But, perhaps more importantly, it fails the basic test of a scientific model: that it must faithfully reflect the real world it is describing. There are strong grounds for believing that people, or a substantial number of them, are not doing the kind of continuous intertemporal optimisation assumed by the model.

Evidence is found in the latest Scottish Widows Saving and Investment Report.

It finds overall retirement savings have hit an all-time low, with only 46 percent of people saving enough for their retirement. It reveals stark differences between people's expectations and reality.

Despite a big fall in retirement savings, it seems that people's aspirations for their pension income have actually increased by £200 from 2011 to 2012. The survey findings show that the average level of annual income people would feel comfortable living on at 70 years-old is now £24,500 compared to £24,300 in 2011. But the savings rates reported are unlikely to be able to produce a pension at age 65 of more than half that figure. Moreover 41 percent say they would like to retire at age 60.

That is not all. More than one-in-five (22%) of people in work aged over 30 and earning more that £10k are saving nothing at all for their retirement.

This is evidence of great heterogeneity of behaviour, with some households optimising like the model says, but as many failing to do so. How, then, can a model assuming universal intertemporal optimisation of consumption be taken to represent this reality? Surely what is needed is a way of describing behaviour which allows for statistical variation and behavioural heterogeneity - captured by Keynes's phrase, "by and large and on the average", he used to desribe the propensity to consume.

As a non-economist who saw the housing bubble in real time,clear as day, it is quite obvious that the problem is not about sophistication ( or lack thereof) in analysis.

There were Austrians and Keynesian both screaming about evidence of a housing bubble, and it was clear from basic metrics like the ratio of the median wage to median home prices and mortgage payments, that this was unsustainable.

The fact that we continue to increase productivity, means that consumption must increase proportionately, or unemployment will rise. Debt is money owed to each other, and when one group chronically has too much debt to another group that has so much money it doesn't know where to put it, that is clearly not sustainable.

We have ever increasing wealth, but our political and economic systems are failing us, in terms of distribution of the costs and benefits, in a way which is fair, stable and sustainable.

In the 1960's,it was common wisdom that the increases in productivity would allow us to all work shorter weeks, retire earlier, and still be wealthier.

Yet now, with high unemployment, "common wisdom" states that we must raise the retirement age, even though that will only transfer (on net) people from SS, to Unemployment Insurance (or the gutter). Sheer madness - the result of years of paid economic shills, groupthink, and "pragmatism" - meaning only those who spout the views of the wealthy and corrupt, are allowed to hold the microphone, and speak to the People.

Krugman shares your views but disagrees on some elements.http://krugman.blogs.nytimes.com/2012/07/13/gadgets-versus-fundamentals-wonkish/#commentsI believe Krugman is right, but I wish you continue with that topic. It is a very important debate that needs to be kept alive, and what you said so far was quite relevant (and inspirational... http://www.98economics.com/2012/07/why-models-cannibalized-economic.html)

>"To me the most astonishing thing was that all these textbooks do not find an analytical explanation of unemployment," he said. "I was really amazed.">>Up to one in four people can't find work in parts of Europe, and the reality of people who are unemployed without choosing to be is one of the biggest holes in mainstream theory, for Bofinger and others.

Sad but true! Job creation, AND an explanation for unemployment (first post on site): http://jobcreationplan.blogspot.com/

It seems possible to me that the primary economics lesson learned from the period before, during and after the meltdown is that economics and more specifically economists don't offer enough to matter enough.

Perhaps what we all need is for the econ world to launch an all hands on deck moonshot style project - an Economics Moonshot. It's still early in the decade, but to be fair, we'll give you a full 10 years. We'll put you (ALL) up on some island ( or here in AZ... plenty of space ) and no one leaves until you've floated weightless, space walked, orbited and landed on enough celestial bodies, drank enough Tang and peed in enough vacuum tubes to solve this one use case:

Barney Frank pulls up to his favorite fast food restaurant. Voice over the intercom: "Hello sir, may I take your order?"

Barney: "Yes, I'd like 3 burgers - no onions, 2 large fries, with cheese, a jumbo cola .. umm.. make it a diet cola."

Voice: "Okay. Will that be all?"

Barney: "No. Also, tell me what will happen to the U.S. economy if we pass a law that mandates...."

Voice: "Is that w/ the standard 1,2 and 5 year analysis?"

Barney: "Ummm.. No, better throw in year 10. It's an election year."

Voice: "Okay. Got it. Pay at the first window, please."

Crack that nut, then you can come back and join the rest of us... and matter a whole lot more.

I know, that sounds harsh. I really don't mean it to. I tell ya what. As a sign of good , I'll match your economists 1 for 1 with computer scientists. Kinda like a buddy system. A computer dude will shadow each econ dude (dudettes allowed too, of course) in order to be able to get what's in the econ dude's head into the software. (Oh, by the way, computer scientists build actual systems, not just paper systems ;-)

And perhaps for no more reason than it is '10's and not the '60's, we'll make the project a Big Brother style reality TV show.

>The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?

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